Econ 101: Central Banking and the Federal Reserve System

For our discussion of central banking, I want to give some brief background and then describe for you the mechanism by which America’s central bank, the Federal Reserve System (hereafter called “the Fed”), creates money out of nothing. An understanding of this process is crucial to the understanding of business cycles (the “boom” and “bust” times for the economy) to be covered in the next (and final) article.

National central banks are established for a variety of reasons both public and private. Publicly, central banks are said to be “lenders of last resort,” meaning that if local banks get low on funds and can’t (or won’t) raise cash by other means, they can get loans from the central bank in order to stay in operation. The central banks are also usually charged with setting the rate of inflation, and, in the case of the Fed, maintaining full employment for the nation as a whole.

Central banks are usually seen to be a part of the national government, and in most cases they are. In the U.S., however, the Federal Reserve System is a hybrid, in that it is privately owned, but it was created by an Act of Congress and its Board of Governors is appointed by the President of the United States. The Fed is, in fact, a cartel of several large banks which have been given authority over the control of the nation’s money supply and rate of inflation. Established by the Federal Reserve Act of 1913, it was publicly touted as a way to keep banks from failing and from over-inflating. What it has done in reality has been to prop up big banks when they’ve made bad decisions, to continually inflate (and therefore devalue) the dollar over the past 100 years so that it’s lost (arguably) 95-98% of its purchasing power, to allow the U.S. government to finance large-scale operations that could never have been funded by tax dollars (e.g., long wars), and to wreak havoc on the free market system. This sounds a bit over the top on re-reading, but it’s absolutely true. Here’s how the system works:

When the Fed sets out to lower interest rates, it does so by infusing banks with new money. The expectation is that the banks, now having a larger supply of money, will lend it out at lower interest rates in an effort to entice potential borrowers. This goes back to our discussion of supply and demand, where – all else being equal – an increase in the supply of a good or service will tend to decrease its price. The Fed gets the new money by creating it out of nothing. The money-creation process goes like this:

1) The Fed’s Open Market Committee (FOMC) buys something by writing a check for that thing. The item purchased could be anything, but is most commonly a large bulk of United States Treasuries (bonds). At this point the new money does not yet exist.

2) The recipient of the Fed’s check takes it to his bank to be deposited in his/her account. At this point the new money still does not yet exist.

3) The recipient’s bank takes the check to the Fed and redeems it by depositing it in their account with the Fed. Here is where the money actually comes into being. But it doesn’t stop there.

4) The bank’s account with the Fed is their “reserve” account. The Fed has a table regulating how much must be kept on reserve based on a bank’s existing capital, but for convenience, let’s just use 10%, since that’s the highest amount in the table at present. By depositing a check from the Fed into their account with the Fed, the bank is authorizing itself to lend out 9 times the amount of the deposit.

That’s the deal. The Fed buys something with a check, the check gets deposited at the Fed in the account of a member bank, and a total of 10 times the amount written on the check gets created out of thin air. This, of course, leads to the inflation previously discussed, which is bad enough by itself, and indeed is a “hidden tax” that steals from every dollar-holding person on the planet for the benefit of a very few recipients of the new money. Beyond that, it also sets up the “boom-bust” business cycle that causes such misery across the whole economy. And that will be the topic of the final article in this series.